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Sovereign Credit Rating Changes and Its Impact on Financial Markets of Europe During Debt Crisis Period in Greece and Ireland

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Sovereign Credit Rating Changes and Its Impact on Financial Markets of Europe During Debt Crisis Period in Greece and Ireland International Journal of Academic Research in Accounting, Finance and Management Sciences Vol. 7, No. 4, October 2017, pp. 146–159 E-ISSN: 2225-8329, P-ISSN: 2308-0337 © 2017 HRMARS www.hrmars.com Sovereign Credit Rating Changes and Its Impact on Financial Markets of Europe during Debt Crisis Period in Greece and Ireland Fahad BASHIR1 Omar MASOOD2 Abdullah Imran SAHI3 1,2,3Lahore School of Accountancy UOL Lahore Postcode 54000, Pakistan, 1E-mail: [email protected] 2E-mail: [email protected], 3E-mail: [email protected] Abstract The purpose of this study is to examine the impact of sovereign credit rating changes on financial markets using database of two countries (Greece, Ireland) in the European union over the period March, 2008-Dec, 2015. By analyzing the influence of sovereign credit rating on bond market yield We also examine the correlation between sovereign credit rating and bond market yield of each country during crisis period. Quarterly basis data of all variables is used in the research. By using regression analysis with Durbin Watson test and Pearson correlation for each country financial markets the findings indicated that sovereign credit rating has a significant impact on bond markets. Sovereign ratings are negatively correlated with Bond yield in both countries. The finding summarized that credit rating has a major influence on financial markets during crisis period. Key words Credit ratings, Moody, S&P, Fitch, bond yield, inflation, current account DOI: 10.6007/IJARAFMS/v7-i4/3469 URL: http://dx.doi.org/10.6007/IJARAFMS/v7-i4/3469 1. Introduction “There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who is more powerful”, Thomas L. Friedman on 28 March 1999, in the New York Times Magazine. The 1980 Latin American Financial crises, Asian financial crises in 1997, Russian debt crises in 1998, and recent Eurozone crises that started after U.S crises in 2008, demonstrated sovereign credit risk. When a Country unable to meet its financial obligations especially public debt, it means it may be default. This study explores the debt crisis and importance of credit ratings during financial crisis period. 1.1. Role of Credit Rating Agencies in International financial markets: Credit rating agencies played a vital role in International markets. Many researchers examined the role of credit ratings ( Kaminsky and Schmukler 2002) using rating changes data of S&P, Moody’s and Fitch examined the contagion across securities &countries. Its research confirmed the spillover among markets. Event study is used to examine the impact of credit ratings on stock market indices conveyed information that only downgraded in ratings have impact on financial markets (Brooks et al., 2004). By constructing Speculative market pressure index to examine rating impact on financial markets, they found that Sovereign rating changes & credit outlooks have a significant effect on the size & volatility in case of ratings downgrades & negative outlook (Kraussal, 2005). 1.2. Credit Rating Agencies Industry There are three rating agencies that capture the International financial markets: Moody’s, S&P, Fitch Moody was first rating agency that published its rating in 1909 while S&P published its first ratings in 1923. In 1997-2000, Fitch came into being as a result of Merger between Fitch Investor services, IBCA & Duff 146 International Journal of Academic Research in Accounting, Finance and Management Sciences Vol. 7 (4), pp. 146–159, © 2017 HRMARS &Phelps. Moody’s& S&P have captured the market with 80% of all rating revenue. Fitch rating had successfully captured the niche market for third opinion on many obligors. 1.3. Sovereign Credit Ratings History Modern sovereign ratings are a relatively new phenomenon. Moody started rated sovereigns in 1974, At First, Moody rated Canada, USA and Australia, and in 1975, S&P rated only Canada and United States and the Predecessors Fitch posed no serious challenge to the industry duopoly. Sovereign rating actively grew steadily through the 1980s, but their major focus was on the industrialized countries. In 1990, Sovereign ratings continued to flourish by which time emerging market and transition economics become the key source of growth. At the end of 2002, Moody had its public ratings on 109 Sovereign Governments, S&P 93 and Fitch on 77. Generally, Sovereign rating downgrades are considered to be indications of crisis (Juttner and Crathy, 2000) define rating as a three-notch Sovereign credit rating downgrade on long term foreign currency debt over any six month period. 1.4. Sovereign Credit Rating Criteria Sovereign credit ratings are assessments of likelihood that a borrower will default on her obligations & that is based on overall creditworthiness of a country. Credit rating agencies consider their ratings as forward indications of country risk that debt issuers will not able & willing to made payments of particular rated Instruments. Sovereign credit risk is categorized into two major components economic risk and political risk. Economic risk tells about the ability of sovereign government to repay its obligations on time by considering the qualitative and quantitative factors. There are some determinants which is necessary to assess the solvency and liquidity of Sovereigns for Example, S&P divides these factors into eight categories: political risk, Income and economic structure, economic growth prospects, fiscal flexibility, public debt burden, price stability, Balance of payments flexibility and external debt and liquidity (See Appendixes 1) Moody’s & Fitch also consider the above factors to assess the country willingness or ability to pay its obligations. Table 1. S&P’s Sovereign Credit Rating Criteria Political Risk •Form of government and adaptability of political institutions •Extent of popular participation •Orderliness of leadership succession •Degree of consensus on economic policy objectives •Integration in global trade and financial system •Internal and external security risks Income and Economic •Living standards, income, and wealth distribution Structure •Market versus non-market economy •Resources endowments and degree of diversification Economic Growth Prospects •Size and composition of savings and investment •Rate and pattern of economic growth Fiscal Flexibility •General government operating and total budget balances •Tax competitiveness and tax-raising flexibility •Spending pressures Public Debt Burden •General government financial assets •Public debt and interest burden •Currency composition and structure of public debt •Pension liabilities •Banking, corporate and other contingent liabilities Price Stability •Trends in price inflation •Rates of money and credit growth •Exchange rate policy •Degree of central bank autonomy 147 International Journal of Academic Research in Accounting, Finance and Management Sciences Vol. 7 (4), pp. 146–159, © 2017 HRMARS Balance of Payments •Impact of fiscal and monetary policies on external accounts Flexibility •Structure of the current account •Composition of capital flows External Debt and •Size and currency composition of public external debt Liquidity •Importance of banks, public and private entities as contingent liabilities •Maturity structure and debt service burden •Level and composition of reserves and other public external assets •Debt service track record Source: Standard & Poor’s (2002) 1.5. Sovereign Credit Rating System In order to assign their sovereign ratings the credit ratings apply an ordinal scale. Sovereign credit ratings are divided into three broad categories: 1. Upper Investment Grade; 2. Lower Investment Grade; 3. Speculative Grade. Table 2. Long Term Sovereign ratings Rules S&P Moody’s Fitch Linear Break Upper Investment Grade AAA Aaa AAA 21 AA+ Aa1 AA+ 20 AA Aa2 AA 19 AA- Aa3 AA- 18 A+ A1 A+ 17 A A2 A 16 A- A3 A- 15 Lower Investment Grade BBB+ Baa1 BBB+ 14 BBB Baa2 BBB 13 BBB- Baa3 BBB- 12 Speculative Grade BB+ Ba1 BB+ 11 BB Ba2 BB 10 BB- Ba3 BB- 9 B+ B1 B+ 8 B B2 B 7 B- B3 B- 6 CCC+ Caa1 CCC+ 5 CCC Caa2 CCC 4 CCC- Caa3 CCC- 3 CC Ca CC 2 C C C 1 SD/D Default DDD/DD/D 0 Investment grade issues are considered acceptable for Institutional investors. Fitch and S&P issues rated BBB- and above are as investment grade and Moody’s split it at Baa3 and above. Sovereign ratings rules described in the research shows that S&P and Fitch run from AAA, the highest through AAA up to BBB which is considered as Investment grade and then when it is going to be down at D which shows the potential default of a country. In contrast, Moody sovereign ratings range from “Aaa” category at the top Ca, Cc, C category at the last which is consider to be default. Different numeral values are assigned to these rating ranges from A to D. Linear transformation scales are used for giving numeral values to ratings, they 148 International Journal of Academic Research in Accounting, Finance and Management Sciences Vol. 7 (4), pp. 146–159, © 2017 HRMARS used values from 1 to 20 top value given to top rating and lowest to lowest ratings (Kraussal, 2003; Lee 2003). By using as a base (Yun Lai 2013): I assigned 0 value to D, 1 for C, 2 for cc/ca,3 for ccc-/caa3,4 for ccc/caa2,5 for ccc+/caa1,6 for B-/B,7 for B/B2,8 for B+/B,9 for BB-/Baa3,10 for BB/Ba2,11 for BB+/Ba1, 12 for BB-/Baa3, 13 for BBB/Baa2,14 for BBB+/Baa1,15 for A-/A3,16 for A/A2,17 for A+/A1,18 for AA-/Aa3,19 for AA/Aa2, 20 for Aa1/AA+ and 21 for AAA/Aaa. Long term foreign currency ratings and short term foreign currency ratings are used as a major variable in the research.
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